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Eco351 assignmentt 4

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Homework
Assignment #4– Econ 351 –Fall 2013 – PLEASE STAPLE, DUE, Wednesday, November 20 at
the beginning of class. NO LATE HWS
ACCEPTED –

YOU MUST USE THIS
AS A TEMPLATE – Please be a neat as possible, especially with graphs and please
show all work. HIT ENTER TO MAKE ROOM
FOR YOUR ANSWERS. PLEASE STAPLE!

THE TERM AND RISK STRUCTURE OF INTEREST RATES

In this HW
assignment we are going to consider 4 specific relatively recent episodes in
the US
economy – 2 of the 4 apply mainly to the term structure of interest rates and
the other two apply mainly to the risk structure of interest rates. In this assignment you are getting your hands
dirty with real economic data (interest rates) and then you graph the data and
interpret (You need to know a little
about excel – if you need help see me or a friend)!

.jpg”>1) EPISODE #1! GREENSPAN
THE HAWK!!! It was November 1994 and the
US
economy had just ‘gotten through’ the jobless recovery following the 1990 – 91
recession. The graphic below helps us
understand what Greenspan was thinking – The Fed has a dual mandate and
unemployment rates above 7% is certainly not consistent with the full
employment objective. As such, Greenspan
was dovish
in the sense that he continued to lower the federal funds rate until it hit 3%
(see FF graphic). At the time, inflation
was running about 3% which implied the real federal funds rate was zero,
certainly falling into the category of easy or expansionary policy. What we are
interested in is the behavior of the yield curve towards the end of this
episode.

BOTH GRAPHICS –
MONTHLY DATA (8/1990 – 11/1994)
.jpg”>.jpg”>Note that during 1994 the Fed was quite aggressive in
raising the funds rate and this is when AG showed his “Hawk-like
qualities.” In particular, the funds target rose from 3% to 4.75% during the
first 10 months of 1994. Greenspan, as
was the norm, was looking very closely at the behavior of the 10 year Treasury. In what follows, you are to examine the
behavior of the yield curve during this job-less recovery episode. To do so, we need data on the three – month
T-bill and the 10 year Treasury (Click .stlouisfed.org/fred2/series/GS3M?cid=115″>Here for
the T-bill data and .stlouisfed.org/fred2/series/GS10?cid=115″>Here for
the 10 year Treasury data).[1] Please choose “download data” and create a
worksheet with data that begins in August 1990 and goes through to the present
(we will use data later in the sample in a different episode). Your worksheet should begin looking just like
the one below.

3
month T bill

10
Year Treasury

1990-08-01

7.69

8.75

1990-09-01

7.60

8.89

1990-10-01

7.40

8.72

1990-11-01

7.29

8.39

1990-12-01

6.95

8.08

Below is an excerpt from

Fed Chief’s Style: Devour the Data, Beware
of Dogma
As Retirement Looms in 2006 – Write a paper; Professional research paper writing service – Best essay writers, Greenspan’s
Strong Record Will Be Hard to Replicate
Did He Help Create a Bubble?
By GREG IP
Staff Reporter of THE WALL STREET
JOURNAL
November 18, 2004; Page A1
1994: Soft
Landing
In the first eight
months of 1994, in a bid to slow the economy, the Fed raised its short-term
interest rate five times, or a total of 1.75 percentage points, to 4.75%. The
Greenspan Fed had a long tradition of moving in small increments, hoping to
give officials time to assess the impact on corporate borrowing or consumer
spending before moving again. Changing rates too rapidly, the theory went,
risked an unnecessarily sharp slowdown and higher unemployment.
But the economy showed
no signs of slowing. Investors still worried about inflation — then running at
an annual rate of about 3%. That concern
led the bond market to drive up long-term interest rates. When bond buyers
worry their investment will be eroded by inflation, they typically demand a
higher rate of return as compensation (THIS IS THE FISHER EFFECT!!!).
The Fed’s challenge
was to raise rates enough to slow growth and yet also contain inflation — an
elusive combination called a “soft
landing.” But the Fed might raise rates too much, or the
inflation-obsessed bond market could drive up long-term interest rates too
high, causing the economy to fall into recession with a “hard
landing.” THIS IS WHY THE FED IS SO VIGILANT ON ANCHORING INFLATION
EXPECTATIONS BECAUSE IF THEY BECOME UNANCHORED, POLICY BECOMES VERY DIFFICULT
VERY FAST.
In November 1994, Mr.
Greenspan made a dramatic proposal to the Federal Open Market Committee, the
body that votes on interest rates: Jack
up the Fed’s key short-term interest rate by three-quarters of a percentage
point in one shot, something he had never recommended before. Mr. Greenspan
believed such a move would demonstrate the Fed’s resolve and finally stamp out
inflation worries (TOTALLY HAWKISH)
“I think that we
are behind the curve,” he told the Fed’s policy committee, transcripts
show. Doing less, he said, could undermine confidence in the Fed’s ability to
control inflation. With none of the ambiguity that marked his public
statements, Mr. Greenspan said such an eventuality could provoke a “run on
the dollar, a run on the bond market, and a significant decline in stock
prices.”
Some of the six other
governors and 12 regional bank presidents who made up the FOMC worried Mr.
Greenspan was overdoing it. Especially concerned were two new Clinton-appointed
governors, Janet Yellen and Mr. Blinder,
academic economists inclined at the time to worry more about unemployment than
inflation. THIS IS THE DEFINITION OF
BEING DOVISH “There is a real risk of a hard landing, instead of a
soft landing, if we are too impatient and overreact,” Ms. Yellen, who is now president of
the San Francisco
regional bank, told the committee.
a) (10 points)
We know that the Yield curve typically slopes upward due to the term
premium and we also know that the Yield Curve slopes upward when short rates
are abnormally low. Greenspan was
watching the 10 year and the slope of the yield curve carefully during the Fed’s
tightening of 1994 and was upset. Why
was he upset exactly? Use the real data that you downloaded and use the Fisher
equation and Fisher effect to buttress your argument.
b) (10 points) As a
result of these developments, Greenspan decided to crank the funds rate target
up by 75 basis points at the November
1994 FOMC meeting. Greenspan continued
to watch the 10 year very closely and was he satisfied with the result? Why or why not? Explain. Consider the
movement of the 10 year from November 1994 through June of 1995.
c) (10 points) Now draw
two yield curves on the same diagram.
The first, label YC11/94 and the second label YC6/95
being sure to label everything with actual numbers!. Comment on the difference in the shape and
what this means, theoretically in terms of the future path of short term
interest rates employing the pure expectations theory of the term structure. Be
sure to explain how and why the 75 basis point move at the November meeting seems
to have ‘done the trick.’
d) (5 points) Finally,
I often use the following phrase and sometimes suggest to students to go home
over Thanksgiving and tell their parents that the Fed lowers interest rates by raising them! Is there any merit to the phrase given this
episode of 1994? Why or why not?
EPISODE #2 – THE
RUSSIAN FINANCIAL CRISIS OF 1998. For
this episode, we are going to focus on the risk structure of interest rates and
the signal it sends as to the state of affairs in the credit markets. We are again going to download and graph some
data. In this exercise, we are using daily
data. We can do this with two series,
the rate on 3 month AA financial commercial paper and our friend, the 3 –month
T-bill (daily). Note how we match maturities, critical when evaluating the risk
structure of interest rates. Click .stlouisfed.org/fred2/series/DCPF3M?cid=120″>Here for
the commercial paper data and .stlouisfed.org/fred2/series/DGS3MO?cid=115″>Here for
the T-Bill data. Parse your data so that
it begins in Jan 1998 and continues through to the present (we use the later
data for Episode #4) Make a third column and call it the spread (icp
– iT-Bill). The spread is the
signal!! The beginning of your worksheet should look like the one below:

3month commercial
paper

3M T-Bill

spread

1998-01-01

#N/A

#N/A

#N/A

1998-01-02

5.57

5.32

0.25

1998-01-05

5.53

5.23

0.3

1998-01-06

5.51

5.22

0.29

1998-01-07

5.48

5.23

0.25

1998-01-08

5.48

5.13

0.35

1998-01-09

5.42

5.05

0.37

1998-01-12

5.39

5.12

0.27

1998-01-13

5.37

5.17

0.2

1998-01-14

5.41

5.18

0.23

1998-01-15

5.41

5.13

0.28

a) (5 points) Note the
relatively low spread during the beginning of 1998. What does a low spread indicate with regard
to these credit markets? In your answer,
mention what it means if the spread was
zero!
b) (10 points for
explanation) The Russian default occurred on August 17, 1998 Please graph (10 points for correct
graph) the paper – bill spread from
August 17, 1998 until November 30, 1998 (line graph using excel) and comment on
the movement of the spread during this time period. Be sure to explain why the spread changed
during this period and what signal it sent to policy makers. Was the movement
in the spread due primarily to changes in the paper rate or changes in the rate
on T-Bills or a little of both? Why would we expect the T-bill to move as it
did during this crisis?
c) (10 points) On what
day, during the fall of 1998 did the spread hit its highest point at what did
the Fed do about it. Click .federalreserve.gov/monetarypolicy/fomchistorical1998.htm”>Here
for some help. In your answer, provide
all the policy changes(as defined
by changing the target for the federal funds rate) and the associated dates,
conducted by the FOMC during the fall of 1998.
EPISODE #3 – THE
CONUNDRUM!!! During the ‘Job-loss’ recovery following the 2001 recession,
Greenspan arguably kept interest rates “too low for too long.” In this episode, we turn our attention to the
tightening cycle that began June 30, 2004.
Beginning with this FOMC meeting, the Fed raised the target for the
federal funds rate by 25 basis points 17 FOMC meetings in a row.
a) (10 points) –
according to the pure expectations theory of the term structure (PET), comment
on the implied movement of long term interest rates such as the 10 year
Treasury. Please explain using the equation that determines the yield on 10
year Treasury according to PET.
b) (5 points) We now
consider the facts and the so-called .msnbc.msn.com/id/8148664/ns/business-eye_on_the_economy/t/greenspan-wrestling-rate-conundrum/#.TrUnx7KczTo”>conundrum.
Using the worksheet that you created for Episode #1 (monthly), consider the
level of the T-Bill and compare it to the rate on the 10 year in May 2004, a
month before the tightening cycle began.
Is the slope of the yield curve during this time consistent with PET and
the term structure facts? Why or why not?
c) (10 points) Now consider the sample period from May 2004
through December 2006 – Write a paper; Professional research paper writing service – Best essay writers. Comment on the
movement of the T-Bill and compare to the movement on the 10 year. Are these movements consistent with PET? Why
or why not?
d) (10 points) Using
the liquidity premium theory of the term structure (write it out), give an
alternative explanation of the facts – that is, explain why short rates kept
going up but the 10 year didn’t budge! Click .federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm”>Here
for a big hint.
EPISODE #4: THE
BEGINNING OF THE GREAT RECESSION AND THE COLLAPSE OF LEHMAN BROTHERS. In this problem, we are going to let the data
on the risk structure of interest rates, the
daily data, identify the beginning of the Great Recession as well as
identify the collapse of Lehman Brothers.
a) (10 points for
graph and 10 points for explanation) Provide a graph of the paper – bill spread
during the entire month of August 2007.
Identify the date that this spread peaked and was the Fed and the FOMC
doing anything about it – if so, what?
Go .federalreserve.gov/monetarypolicy/fomchistorical2007.htm”>Here
for some help! Be sure to include all the Fed’s activity during August of 2007.
b) (10 points for
graph and 5 points for explanation) We now consider the Lehman collapse – this
occurred as you may know during September 2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers. Provide a graph of the paper –
bill spread during the entire month of September 2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers (again, use excel). Identify the date that this spread peaked and
is this the date that Lehman went down? What else was happening during this
week? Click .stlouisfed.org/index.cfm?p=timeline”>Here for some
help.

[1] We could use some more rates in between the three month T-bill and
the 10 year T-note to get a more accurate yield curve but these two rates will
do the job.

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